Understanding Tax Deductibility of Legal Fees in California

What are Legal Fees?

Legal fees generally refer to the fees incurred in retaining an attorney to provide legal services. The types of legal services for which fees may be incurred can vary widely. For example, some might retain an attorney to draft a Will, while others might hire an attorney to prepare and file a lawsuit. In other cases, fees are incurred because one is defending against a lawsuit, or seeking to enforce a contract . Fees may also include those incurred to prosecute a marital dissolution proceeding and related action, such as a request for separate support or termination of another marriage, as well as fees incurred to enforce or challenge a Marital Settlement Agreement. As can be seen from this list, legal fees can accrue in many circumstances.

Broad Guidelines for Legal Fee Deductibility

Neither the federal Internal Revenue Code nor the California Revenue & Taxation Code provides a specific definition of "legal fees." Therefore, the General Rules generally apply when determining which legal fees are deductible and which are not. Under them, IRS regulations state that legal fees may be deducted as "trade or business expenses," rather than itemized as "personal, living and family expenses," only in three circumstances:

• The legal fees were paid to protect or produce taxable income (e.g., new employment contracts, settlements of employment disputes or for estate planning).
• The legal fees were incurred to protect or produce a "profit-seeking" activity.
• The legal fees were incurred to conserve principal or generate taxable income from the taxpayer’s "personal residence" (e.g., defense of easements or restrictive covenants or obtaining a variance).

Legal fees incurred in connection with typically "personal" or "family" matters (e.g., child custody disputes, wills or probate transactions), or for non-taxable activities, cannot be deducted by the taxpayer.

Tax Deduction Laws Specific to California

When dealing with legal fees, California law notably differs from federal tax law. California has additional rules concerning which legal fees are deductible and when the business may deduct them.
Legal fees are deductible to the extent they are necessary and ordinary for the conduct of the taxpayer’s trade or business. Accordingly, the legal fees associated with the preparation of a contract (not signed yet) are not deductible as a business expense.
Organizations that conduct a business in California must file a California corporation franchise or income tax return. The laws of California do not allow any deduction of "entertainment expenses" such as meal expenses or the expenses for entertaining your client.
In addition, unlike federal tax law, California law does not provide for the further deduction of fees as an "above-the-line" deduction. California law simply conforms to federal law with respect to the deductibility of premiums paid on qualified mortgage insurance.

Personal Legal Fees vs. Business Legal Fees

The difference between business legal fees and personal legal fees is an important, and often forgotten, issue in California when people are trying to determine whether the fee their lawyer charged is tax deductible.
Business legal fees are those fees incurred by either an employee or self employed individual. They are incurred in connection with a business for the production of income. For example, fees for a self employed person to fight an eviction would be deductible if they were trying to retain office space to conduct their business. Similarly, legal fees in connection with a business contract for services contracted by a corporation would be a business expense. While a non-lawyer might think that just because a person might have been involved in a personal relationship with the people involved in the contract dispute, that it is not a business expense. What the IRS looks at is the nature of the relationship and the case. If the person would have been involved in the relationship anyway (for example as the accountant), then the deduction can still stand. An accountant might contract for services that are not employee-employer, but still in the same ways that the employee does for their employer. This is a business expense, even if not technically an employer-employee relationship.
Personal legal fees are legal fees that are not related to the client’s or taxpayer’s business and are not incurred in connection with business activities. Personal legal fees are reported on the taxpayer’s individual income tax return as itemized deductions on Schedule A. Such fees include, for example, personal representation involving divorce, spousal support, child custody, visitation, restraining orders, modification of custody and visitation and other issues connected with a dissolution of marriage.

Fees Related to Employment

As a general rule, the costs of a lawsuit are not deductible. This is true even if you win the case as a plaintiff. "No deduction is allowable on account of the costs of a suit or other litigation, except as expressly provided by law." (26 U.S.C. section 2621). Consequently, you cannot deduct the costs of a lawsuit you might bring against an employer for wrongful termination or for failing to accommodate a disability, sexual harassment or discrimination claims. Employment cases are, however, an exception to the above rule with respect to deducting legal fees that are related to your employment and thus proximately incurred in your business. The Supreme Court, in the case of North American Oil Consolidate v. Burnet (1932), 288 U.S. 1, held that the ordinary and necessary costs of carrying on a trade or business are deductible. The Court further held that, in determining whether a proposed expenditure is ordinary and necessary, the Court should look to whether the expense was common and accepted practice. In General Counsel of the United States v. Roderick-MacKenzie Co., the Supreme Court acknowledged that the suggested guidelines for guidance under IRC section 162(a) was flexible and should be applied without a narrow and rigid set of rules. The Court went on to state that the expenditure must be both of the type that is commonly considered as associated with the taxpayer’s business affairs and also appropriate with respect to that particular taxpayer’s business. The Court reiterated this position in United States v. Correll, (1953) 389 U.S. 299, 302. The Court in the case of Brannen v. United States was in accord with its previously established precedent. In Brannen, the Tax Court concluded that expenses incurred to defend employment discrimination suits and breach of contract suits were proximately connected to the taxpayer’s trade or business of acting as a distributor and wholesaler. As a result, the Tax Court concluded the legal and consultant fees associated with those suits were deductible expenses. As an illustration: "A part time businessman engaged in the commercial fishing business did not deduct legal expenses incurred in connection with lawsuits arising out of a collision between two boats even though the corporation had settled some of the litigation by paying amounts to victims." The later case of Goodman v. United States, 176 F.Supp.2d 842 (W.D. Mich. 2001) interprets the Brannen case in the following manner: "the issue is whether the lawsuit expenses have proximate relation to the trade or business in which the taxpayer is engaged at the time of the litigation." While the test for deductibility considers a proximate relation to the trade or business of the taxpayer, the taxpayer’s trade or business will be of primary importance. If the taxpayer does not have an established trade or business at the time of filing the lawsuit or the lawsuit does not involve the $1 million or more claim threshold, the deductibility of the costs may well be compromised. The claim threshold refers to those claims that will allow the deduction of legal fees regardless of your trade or business – a million dollar claim against the other party eliminates the general disallowance of legal fees to the originating party. Claims exceeding $1 million must at least have some relationship to the company’s trade or business in order for the attorney’s fees and costs to be deductible. Consequently, a separate issue will be presented if your claim is less than $1 million and is untethered to your trade or business. In short, litigation will be more successful if it involves a direct relationship between the claim and your business. In this situation, the legal fees paid will be deductible. The deduction applies to a variety of situations. For example, where an employee incurs legal expenses in contesting an adverse action resulting from the company’s pension, profit-sharing, or stock bonus plan. The deduction will likewise apply to an employee who incurred legal expenses in defending a complaint filed against him by the Social Security Administration and his employer. The deduction shall also apply to the defense of actions brought by the employee because of fraud, misrepresentation, breach of contract, or other misconduct committed while employed. There are two other narrow exceptions where legal fees incurred in connection with the sale of a business may be deductible. The first is an individual who makes payment pursuant to a valid indemnity agreement for damages resulting from a breach of a representation or warranty made by the indemnifying party. The other exception is sales commissions for sales upon termination of employment. It should be noted that there are very specific dollar thresholds and timing in the deductibility of legal fees. As the examples cited above are illustrative, the deduction of legal fees will be fact specific. To take advantage of these tax deduction opportunities, you should consult your tax advisor.

Divorce-Related Legal Fees and Deductibility

The answer to whether legal fees in connection with a divorce are tax deductible will depend on the purpose of those legal fees. If they are paid for the production or collection of taxable alimony or the production or collection of taxable income, then they are deductible as a miscellaneous itemized deduction. This means that the legal fees add to other itemized deductions like property taxes and mortgage interest not subject to any applicable limitation or disallowance, and subject to the 2% floor on miscellaneous itemized deductions.
On the other hand, if the legal fees were incurred to obtain a property settlement or to obtain or defend against a request for child or spousal support, then they were not incurred in relation to the production of taxable income or alimony and are not deductible at all.
It is important to understand that if the taxpayer is not liable for tax on the income of a trust because the income is distributed to the trust beneficiary, the trust beneficiary may not claim a tax deduction for legal expenses paid in order to establish the trust, or to keep the trust from being dissolved or receiving property.
In California, attorneys in divorce cases frequently see the entire retainer fee paid up front . The retainer fee under California law is treated as a deposit for services to be rendered by the lawyer and should be treated as such by the client (or clients). That means the retainer fee should not be apportioned out over the course of the representation. The legal fees should be deducted based on the legal services performed in a particular tax year. As a result, a client who pays a retainer fee or a flat fee for legal services in 2015 and does not claim the legal expense deduction until 2016 may not be able to deduct the legal fees paid in 2015.
If a couple is not divorced until 2016, then the deductibility of legal fees becomes a moot point. However, if the couple obtains a divorce in 2015 but a Judge orders one of the parties to pay fees to the other in 2016, that payment is not deductible in 2016 because it did not arise out of the 2016 divorce. Similarly, if a couple obtains a divorce in 2016 but one of the parties makes a lump sum payment for fees incurred in 2015, that payment would not be deductible in 2016 because it did not arise out of the 2016 divorce.
While we normally think of legal fees as nondeductible, there are exceptions to the rule.

How Legal Fees are Claimed as Deductions

If you pay a legal fee to obtain a settlement, judgment, award of back pay or damages in California, you can very often deduct those fees (whether paid to your attorney or to the Internal Revenue Service for taxes owed) on your tax return. But claiming those deductions on your California return can be more complex than doing so on your federal return.
Deductions on your federal return are straightforward, but that does not guarantee that you will actually receive the benefit. After you have determined the amount of your legal fees that are deductible, you must itemize your deductions by filing Form 1040, Schedule A. The deduction for legal fees will be taken in the category to which the fee applies. For example, the proper deduction for a legal fee paid to a criminal attorney for a criminal case is the "taxes paid" category. Deductible legal fees paid to an attorney in an employment-law related case, on the other hand, would be deducted as a "miscellaneous itemized deduction." While there is no limitation on the amount of legal fees (either with regard to the amount or the purpose of the fee) that you may deduct on your federal return, there is a limitation with regard to miscellaneous itemized deductions: those deductions must exceed two-percent of your adjusted gross income. Another limitation is that items deductible as miscellaneous deductions may not be used as a basis for an alternative minimum tax (AMT) deduction. When you pay legal fees for services that are not deductible, such as defending yourself in a civil lawsuit or criminal prosecution, you may not deduct those fees. If you pay legal fees that are attributable to both deductible and nondeductible purposes, the fee must be apportioned based on the relation of the number of hours spent on each task to the total number of hours spent. On a California return, a deduction for legal fees can be taken only if the legal fees would have been allowable as a deduction for federal income tax purposes. So, if the legal fees are not deductible on the federal return, you may not deduct the fees on your California return. However, just as on a federal return, legal fees are deducted as miscellaneous deductions. While California does not impose an alternative minimum tax and therefore there is no limitation on miscellaneous deductions, California law does require that fees related to offsetting tax liability (such as state income tax refunds and credits) be separately identified from those that are not.

Work with a Tax Professional

Even with a basic understanding of the laws that affect the deductibility of legal fees, the intricacies of tax law often require the consultation of a tax professional or an accountant to provide specific advice. This is especially true with certain California laws, which often differ from other states such as federal and New York laws. With issues regarding taxes, nothing should be taken for granted. Every taxpayer’s individual facts and circumstances impact the application of the law, and the several hundred page Publications 17 and 535 provide even more authority and guidance (in addition to judicial authority).

New and Recent Developments

Recently, the Ninth Circuit Court of Appeals held that a taxpayer was entitled to a $27,400 tax deduction for legal fees incurred in prosecuting a lawsuit concerning the taxpayer’s Alaskan commercial fishing business. In Edgerly v. Commissioner, the Tax Court previously denied the deduction upon finding that the legal fees were unrelated to the taxpayer’s trade or business. The Ninth Circuit reversed and remanded, focusing specifically on the nature of damages awarded the taxpayer in his lawsuit. Although the Ninth Circuit could not reverse the Tax Court on this basis due to a lack of supporting empirical data in the Tax Court’s opinion , the Ninth Circuit provided specific guidance to the Tax Court and suggested that the Tax Court in future cases consider categorizing damages claimed by the taxpayer into three separate categories: (1) the taxpayer lost his commercial fishing business; (2) consequential lost profits and (3) restitution for harm that should be disgorged. Consideration of this approach should aid taxpayers in determining whether they may be entitled to deduction, as the first two types of damages are generally taxable, while the third is not.